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MGT604 - Management of Financial Institutions - Lecture Handout 43

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The Collapse of ENRON

Only months before Enron Corporations bankruptcy filing in December 2001, the firm was widely regarded as one of the most innovative, fastest growing, and best managed businesses in the United States. With the swift collapse, shareholders, including thousands of Enron workers who held company stock in their 401(k) retirement accounts, lost tens of billions of dollars. Investigations of wrongdoing may take years to conclude, but Enron’s failure already raises financial oversight issues with wider applications. This lecture briefly examines the accounting system that failed to provide a clear picture of the firm’s true condition, the independent auditors and board members who were unwilling to challenge Enron’s management, the Wall Street stock analysts and bond raters who missed the trouble ahead, the rules governing employer stock in company pension plans, and the unregulated energy derivatives trading that was the core of Enron’s business. Formed in 1985 from a merger of Houston Natural Gas and Inter-north, Enron Corporation was the first nationwide natural gas pipeline network. Over time, the firm’s business focus shifted from the regulated
transportation of natural gas to unregulated energy trading markets. The guiding principle seems to have been that there was more money to be made in buying and selling financial contracts linked to the value of energy assets (and to other economic variables) than in actual ownership of physical assets. Until late 2001, nearly all observers – including
professional Wall Street analysts – regarded this transformation as an outstanding success. Enron’s reported annual revenues grew from under $10 billion in the early 1990s to $101 billion in 2000, ranking it seventh on the Fortune 500. Several committees in the House and Senate have held or plan to hold hearings related to Enron’s fall. The Justice Department is conducting a criminal investigation. The challenge for financial oversight, however, does not depend on findings of wrongdoing. Even if no one at Enron did anything improper, the swift and unanticipated collapse of such a large corporation suggests basic problems with the U.S. system of securities regulation, which is based on the full and accurate disclosure of all financial information that market participants need to make informed investment
decisions.

• Auditing Issues

Federal securities law requires that the accounting statements of publicly traded corporations be certified by an independent auditor. Enron’s outside audits have received much attention. While external audits do not prevent corporations from making financial mistakes, let alone bankruptcy, problems with recent Enron audits may have contributed to both the rapid rise and the sharp fall in its stock price. Outside investors, including financial institutions may have been misled about the corporation’s net income (which was subsequently restated) and contingent liabilities (which were far larger than generally known). The auditor, Arthur Andersen, has admitted some mistakes. Andersen fired the partner in charge of Enron audits on January 15, 2002, and Enron dismissed Andersen on January 17. One issue is whether Andersen’s extensive consulting work for Enron may have compromised its judgment in determining the nature, timing, and extent of audit procedures and in asking that revisions be made to financial statements, which are the responsibility of Enron’s management. Questions have also been asked about Andersen destroying documents and e-mails related to its audits. Oversight of auditors has primarily rested with the American Institute of Certified Public Accountants (a nongovernmental trade group) and state boards of accountancy. On January 17, 2002, the Chairman of the Securities and Exchange Commission (SEC) proposed a new oversight board that would be responsible for disciplinary actions.

• Accounting Issues

The Enron controversy involves several accounting issues. One concerns the rules governing whether the financial statements of special purpose entities (SPEs) established by a corporation should be consolidated with the corporation’s financial statements; for certain SPE partnerships at issue, consolidation is not required if among other things an independent third party invests as little as 3% of the capital, a threshold some consider too low. A second issue concerns the latitude allowed in valuing derivatives, particularly nonexchange traded energy contracts. Third, there are calls for improved disclosure, either in notes to financial statements or a management discussion and analysis, especially for financial arrangements involving contingent liabilities. Accounting standards for corporations are set by the Financial Accounting Standards Board, a nongovernmental entity, though there are also SEC requirements. (The SEC has statutory authority to set accounting standards for firms that sell securities to the public.)

• Pension Issues

Like many companies, Enron sponsors a retirement plan – a “401(k)” – for its employees to which they can contribute a portion of their pay on a tax-deferred basis. As of December 31, 2000, 62% of the assets held in the corporation’s 401(k) retirement plan consisted of Enron stock. Many individual Enron employees held even larger percentages of Enron stock in their 401(k) accounts. Shares of Enron, which in January 2001 traded for more than $80/share, were worth less than 70 cents in January 2002. Consequently, the company’s bankruptcy has substantially reduced the value of its employees’ retirement accounts. The losses suffered by participants in the Enron Corporation’s 401(k) plan have prompted questions about the laws and regulations that govern these plans.

• Corporate Governance Issues

The role of a company’s board of directors is to oversee corporate management to protect the interests of shareholders. However, in 1999 Enron’s board waived conflict of interest rules to allow chief financial officer Andrew Fastow to create private partnerships to do business with the firm. These partnerships appear to have concealed debts and liabilities that would have had a significant impact on Enron’s reported profits. Enron’s collapse raises the issue of how to reinforce directors’ capability and will to challenge questionable dealings by corporate managers. Specific questions involve independent or “outside” directors. (Stock exchange rules require that a certain percentage of board members be unaffiliated with the firm and its management.)

• Securities Analyst Issues

Securities analysts employed by investment banks provide research and make “buy,” “sell,” or “hold” recommendations for the use of their sales staffs and their investor clients. These recommendations are widely circulated and are relied upon by many investors throughout the markets. Analyst support was crucial to Enron because it required constant infusions of funding from the financial markets. On November 29, 2001, after Enron’s stock had fallen 99% from its high, and after rating agencies had downgraded its debt to “junk bond” status, only two of 11 major firm analysts rated its stock a “sell.” This performance added to concerns that were raised in 2000 in the wake of the “dot com” stock crash.

Derivatives Issues

The core of Enron’s business appears to have been dealing in derivative contracts based on the prices of oil, gas, electricity and other variables. For example, Enron sold long-term contracts to sell energy at fixed prices. These contracts allow the buyers to avoid, or hedge, the risks that increases (or drops) in energy prices posed to their businesses. Since the markets in which Enron traded are largely unregulated, with no reporting requirements, little information is available about the extent or profitability of Enron’s derivatives activities. Did Enron earn money from dealer commissions and spreads, or was it actively speculating on future price trends? Speculative losses in derivatives, perhaps masked by “creative” accounting, could have contributed to the firm’s downfall. On the other hand, the trading operations may have been profitable and trouble free, and Enron’s financial difficulties the result of other unrelated operations. Enron’s collapse raises the issue of supervision of unregulated derivatives markets.

Corrective Actions

The collapse of Enron proved to be a valuable wake-up call to a number of affected groups. The following actions have already been taken by private organizations: The Business Roundtable, composed of the chief executives of about 150 large firms, urged corporations to adopt a number of voluntary changes in corporate governance rules, including that a ‘‘substantial majority’’ of corporate boards be independent ‘‘both in fact and appearance.’’ The New York Stock Exchange and the National Association of Securities Dealers approved major additions and changes in the rules for accounting, auditing, and corporate governance as necessary conditions for listing of a corporation’s stock for trade on the exchange. The major continuing uncertainty is how the exchanges will monitor and enforce these rules. The International Corporate Governance Network, institutional investors that control about $10 trillion in assets, has approved a set of international standards for corporate governance that its members would use their voting power to promote. Standard and Poor’s, one of the three major credit-rating agencies, has developed a new concept of ‘‘core earnings’’ as a measure of earnings from a company’s primary lines of business. Compared with earnings as defined by the generally accepted accounting principles (GAAP), for example, the S&P measure will exclude gains and losses from a variety of financial transactions. S&P plans to report this measure of earnings for all publicly held
U.S. companies.